Is there an argument for an industry standard on ship finance?

Malcolm Strong, partner at Ince & Co, London, questions how owners of substandard vessels gain access to finance

RECENT well-publicised casualties have prompted various reflections, not least on the role of classification societies and how they and other regulatory authorities involved in shipping can be made to function better. But little attention has been paid to how owners of substandard tonnage have been able to obtain finance to assist with the purchase of their ships.

Initially, it might be assumed that a financial institution lending on the security of an asset would take a close interest in the condition of that asset, not least because, in the institution's own interest, the asset itself is its security. A mortgage on a ship at the bottom of the sea, or on which pollution claimants have a prior lien, is of no value. The lender's interest in those circumstances will centre on the insurances on the vessel, which will have been assigned to it. This involves the assumption that such insurances will respond in the event of a casualty. This may or may not be the case. There are numerous reasons why insurers under a hull policy may have a defence to claims by the assured or the lender as the assignee.

If the hull insurances do not respond, the lender will rely on its Mortgagee's Interest Insurance (MII), for which of course the owner will pay. It will seek to recover under its MII policy the insurance which cannot be recovered under the hull policy. These days, the lenders will also usually require Mortgagees' Additional Perils Pollution Insurance (MAP) to protect them against the risk of pollution claimants having priority over their mortgage. The underwriters under MII and MAP policies will in most circumstances be different from those subscribing to the vessel's hull policy.

If so, the question must be asked whether the lender has any real interest in the quality of the asset which it is financing. Traditionally, lenders have looked at features such as the quality of the proposed borrower, the amount of the borrowing as against the potentially available cashflow and the availability of security. For a long time, banks were reluctant to finance vessels over fifteen years of age. The slow pace of replacement of the world fleet, at least until quite recently, has led to a continuing increase in the average age of trading vessels so that, in the interest of finding business, lenders have become willing to finance older vessels

Traditionally, it has been said that lenders "finance shipowners not ships" and the suspicion persists that a greater willingness to finance older ships has not led to any increased interest being taken in the quality of the asset itself. From anecdotal evidence, it seems that ship finance banks do not routinely inspect or value vessels which they are to finance, and that, even with older tonnage, many lenders do not regard it as necessary to inspect the asset which will form the main security for repayment of the loan.

Not for the first time, a lawyer's perspective and a commercial perspective may well be different. A lawyer would inevitably find it surprising that a lender on the security of an asset would not take a close interest in the asset's quality. From a commercial viewpoint, it may be that what matters is the quality of the owner and the economical potential of the vessel.

The fact that the vessel is overage does not mean that its earning potential is poor. The yield in terms of the potential earnings of an elderly vessel against its presumed value is often likely to be higher than for a more valuable, newer vessel. Lenders will say that, like the hull underwriters, they rely on the vessel being in class and, given that classification societies supposedly act in the public interest, this should be a sufficient standard. Furthermore, lenders will require covenants in their loan and finance documentation as to repair and maintenance of the asset as well as compliance with classification requirements.

But the fact that a vessel may meet class requirements is no sure guarantee of its quality. If a vessel proves to be substandard to the extent that it suffers a major casualty. and if it may reasonably be inferred that an inspection at the instance of the lender would or should have caused the lender not to make the loan, or only to make it on terms as to repair of defects as a pre?condition of drawdown, should the lender owe any responsibilities to the public for having participated in an ill-fated venture which, perhaps, has led to serious environmental damage or even loss of life?

As matters stand, a lender not in possession of the vessel, at least under English law, owes no legal responsibility to third parties, the only constraint on the lender's decision to lend being of commercial risk factors. These may not include a close evaluation of the quality of the asset as against the presumed quality of the borrower and the likely cashflow.

Certain conventions such as the Civil Liability Convention, or the Hazardous and Noxious Substances Convention, impose liability on the owner of a ship. Such liability could extend to a lender who is owner of the ship by virtue of a financial lease. Otherwise it is difficult to see, at least as English law stands at the moment, that there is any basis on which a victim of pollution could bring a claim against the lender on a substandard ship responsible for the pollution.

This topic has been the subject of rather more consideration in the United States. The potential liability of lenders, including mortgagees, has been the subject of some attention under the statute known as CERCLA, which deals with land-based pollution. This statute specifically excludes from its definition of 'owner or operator' any person 'who, without participating in the management of a vessel or facility, holds indicia of ownership primarily to protect his security interest'.

There is a suggestion in a widely reported US decision (United States v Fleet Factors) that a secured lender who had the capacity to influence a borrower's environmental management of hazardous materials, but had failed to exercise such capacity, could lose its exemption from CERCLA liability. But the later decision of United States v Bestfoods appears substantially to reduce the risk to such a lender. In any case, in response to pressure from the banking industry, US congress had earlier amended CERCLA to provide protection to lenders and lessors as part of a package of banking reform measures (the Asset Conservation, Lender Liability and Deposit Insurance Protection Act 1996).

Failing some inventive lateral thinking by courts or tribunals in a jurisdiction dealing with a pollution incident, it seems that lenders on substandard tonnage, at least at a legal level, are not likely in any normal circumstances to be held liable to third parties. In this respect they seem to be better placed than some charterers and, in particular, publicly visible oil majors, who have found it increasingly difficult to avoid the commitment of substantial resources to alleviating the results of major pollution incidents, regardless of whether or not they were under legal liability to do so.

However, lenders may wish to consider whether their approach to ship finance should include to a greater extent than at the moment a consideration of the quality of the asset which they are financing. Who knows? At some future date a bank which did not (quite possibly deliberately) investigate the quality of the tonnage being financed or, alternatively, did have a survey carried out but did not require identified problems to be addressed, might be on the receiving end of third party damages claims.

There is at least an argument for an industry standard on the approach to this issue. The stakes in terms of potential environmental damage, and indeed risk to human life, may be too high to allow the matter to continue to be dealt with simply on the basis of commercial assessment of the risks of making the loan.